Trading volume and firm‐specific announcements: Implications for the market model

Abstract

The market model is commonly used in finance to study events and to evaluate security performance. With daily data, it is not uncommon to find low R‐squares, in the range 0–10%. Prior studies have attempted to improve the fit of the model by excluding observations associated with high trading volume. In this study, we compare the results of the high‐volume‐exclusion approach with the more direct firm‐specific announcement exclusion approach. The announcement approach excludes observations associated with Wall Street Journal Index news items regarding the firm. By excluding the [−1,0] fays relative to such news in a sample of 68 firms, we find that R‐squares increase significantly by about 5%. By excluding the days relative to earnings announcements only, R‐squares increase by about 4%. These results are then compared to the high‐volume‐exclusion approach. It is found that this approach is more efficient as an 8% increase in R‐squares is produced.The results of this study provide valuable evidence to empiricists by comparing the two approaches to improving the fit of the market model. The high‐volume ‐exclusion approach provides higher R‐squares. However, the relative efficiency of the two approaches should be balanced against the arguments for the methodologically correct approach. The advantage of using the firm‐specific announcement exclusion approach is that there is more confidence of excluding only firm‐specific movements from the estimation of the market model. It also allows a researcher to quickly and unambiguously identify the announcements and delete the corresponding observations. Furthermore, we find that about 50% of the improved fit, relative to the volume approach, can be accomplished by excluding earnings announcements. The methodological disadvantage of using the high‐volume‐exclusion approach is that it is affected not only by firm‐specific announcements but also by other factors, such as the heterogeneity of investor expectations. These factors may influence the choice of using firm‐specific announcements rather than the high‐volume approach despite the lower increment in R‐squares.